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What Is an Exchange-Traded Note (ETN) – How They Differ From ETFs

By Brian Martucci

investingLike a bond, an exchange-traded note (ETN) is a debt instrument with a set maturity date upon which its issuer promises to repay your investment. However, unlike a bond, it does not accrue interest or guarantee to pay a fixed percentage of your initial outlay. Instead, it tracks an underlying index or asset class, without actually granting ownership in any of its components.

The amount you receive at maturity, or when you sell the bond on the secondary market, is based on the performance of the underlying index – you receive your principal investment plus or minus the gain or loss that occurred during your ownership period. For instance, if you invest $1,000 in an ETN designed to track the price of oil over a period in which its value increases by 15%, you would receive $1,150 upon redemption. If it drops by 15%, you’d receive $850.

ETNs: Definition and Key Features

ETNs have some notable core characteristics. They share many of these with bonds or exchange-traded funds (ETFs).

  • Issue. ETNs are typically issued by large financial institutions, such as Barclays, in batches of at least 50,000 units. Since it’s not practical for regular investors to buy them directly from the issuer – this is typically done by institutional investors – they buy them on the secondary market.
  • Maturity Date. Like unsecured bonds (and unlike ETFs and index funds), each ETN has a predetermined maturity date and is backed by the issuer’s promise to repay its principal.
  • Tracking and Asset Ownership. As debt instruments, ETNs never own assets. They merely track the performance of an index or asset class. Because they don’t own assets, they track this performance exactly. By contrast, ETFs and index funds need to buy and sell assets to mimic the indexes they track. In certain circumstances, this leads to tracking error, a condition where the value of the fund’s holdings doesn’t accurately reflect the value of what it’s supposed to track.
  • Credit Risk. As debt instruments, all ETNs have credit risk. Since they’re only backed by the faith and credit of the issuer, their prices can rise or fall independently of the assets or index they track. In the worst case, you may lose your whole investment in an ETN if its issuer goes under – even if the index it tracks does well. By contrast, since ETFs actually own the assets they track, their market prices are supported by the intrinsic value of the underlying components. Unless the value of all those components drops to zero, the instrument will not be worthless.
  • Liquidity. Like ETFs, ETNs trade on exchanges (the secondary market) and are priced in real-time, although investors are free to hold them until their maturity date. Note that some thinly traded ETNs do have liquidity issues.
  • No Minimum Purchase Requirements. Like ETFs, ETNs are issued at a certain face value, typically $25 per unit with no minimum purchase requirements. By contrast, the minimum purchase requirement on some government and corporate bonds can be $10,000.
  • Expense Ratio. Like ETFs, and unlike bonds, ETNs may come with an annual expense ratio. These ratios can range from less than 0.2% to as much as 1.5%, depending on the complexity of the ETN. For instance, you need to pay 1.35% per year for the highly complex Barclays S&P VEQTOR ETN (VQT), which simultaneously tracks the S&P 500, S&P Volatility Index (VIX), and cash. Its price reflects the optimal allocation between these three indexes at any given time.

Key Distinctions Between ETNs and ETFs

  • ETNs don’t own anything
  • ETNs are far less numerous and popular than ETFs
  • ETFs are more liquid than ETNs
  • An ETN’s value is dependent on its issuer’s credit risk and the value of the index or assets it tracks

Advantages

ETNs have several advantages relative to other investment vehicles, including ETFs, bonds, and stocks:

1. ETNs Perfectly Track the Performance of the Underlying Index

Since ETFs actually own shares of stocks and/or other securities depending on the index they track, they need to periodically rebalance their holdings to ensure that they match the underlying’s performance. This can create a problem called tracking error – a discrepancy between the portfolio of an ETF and the index it follows. Accurately tracking a benchmark index can require a lot of buying and selling – if the individual components aren’t very liquid, it may be difficult to precisely replicate its performance. As an ETF’s holder, this can cut into your returns.

By contrast, the ETN is one of few investment vehicles that’s designed to mimic the performance of an index or asset class without conferring ownership in the underlying securities. Therefore, an ETN’s issuer doesn’t have to worry about periodically rebalancing its assets – and all the problems that process can create. The instrument’s market value simply mirrors that of its designated index or asset basket at all times.

2. Tax Treatment

Relative to bonds, funds, and even regular stocks, ETNs often come with simpler, more attractive tax considerations. Since ETNs generally don’t pay interest, you won’t have to worry about accounting for it every year, as you would with a traditional bond.

The fact that ETNs don’t own any underlying assets means that they don’t have to make annual capital gains distributions either. ETFs, index funds, and closed-end funds that own individual dividend stocks may be required to make annual dividend distributions – another tax consideration that doesn’t come into play for ETN holders. In the majority of cases, you only pay tax (in the form of short- or long-term capital gains, depending on whether you’ve held the instrument for more or less than a year) when you sell your ETN or when it reaches maturity.

3. Total Access to Illiquid or Novel Markets

ETNs give regular investors access to markets and asset classes that might normally be out of reach. While ETFs, index funds, and bond funds offer access to many novel instruments, including currency baskets and commodity futures, they often do so in a way that creates logistical headaches for direct investors. For instance, markets for these instruments tend to be illiquid, and may demand high commissions or minimum investment requirements that are impractical for smaller investors. With no such constraints, ETNs are free to track nearly any investment.

4. Better Flexibility Than Bonds

Since they trade on stock exchanges, they can be bought and sold at any point throughout the trading day. And, like stock and bond trades, ETN trades settle within three business days. And since they typically have a par value of $25 each, compared to $1,000 for an individual bond, it’s more affordable to purchase one ETN unit than one bond – plus, some bonds come with minimum purchase requirements, further increasing their cost.

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Disadvantages

ETNs also have several disadvantages relative to other financial instruments:

1. Credit Risk

As a debt instrument whose value is contingent on its issuer’s credit rating, every ETN comes with some level of credit risk. Even those issued by a financial institution with a solid credit rating, such as Barclays (currently A-, according to Standard & Poor’s), still carry risk. For instance, a mid-2013 reduction of Barclays’ credit rating from AA corresponded to a price drop of several percentage points of many of the company’s ETNs. While bondholders face similar risks, ETF owners aren’t directly affected by changes to the creditworthiness of the issuers of their securities.

2. Fewer Issuers of ETNs

There are roughly seven ETFs for every ETN. Not surprisingly, there are also fewer issuers of ETNs – just nine or ten total, as of 2013. This creates problems for ETN investors.

If you’re looking to capture the performance of a very specific index, you might not be able to find an ETN with the features you want. For instance, the Elements Exchange Traded Notes Spectrum Large Cap U.S. Sector Momentum Index (EEH), which is underwritten by HSBC USA, is the only ETN available to investors who want to take advantage of momentum swings in the S&P 500 Total Return Index (SPTR). On the other hand, even if you find an ETN with suitable characteristics, its issuer may have a sketchy credit rating that makes the instrument too risky for you.

3. Some ETNs Have Liquidity Issues

ETFs trade at higher volumes and generally have higher market capitalizations (the total market value of their outstanding units) than ETNs. As of 2014, the total market capitalization of all outstanding ETFs is about $1.7 trillion. A comparable figure for the ETN market is harder to come by, but it’s undoubtedly far lower – less than $100 billion.

While ETNs offer the market-traded flexibility of stocks and ETFs, some individual ETNs trade quite thinly. Every ETN’s prospectus – and often the disclaimer roll of its issuers’ website – contains a warning that “a market might not develop” after a given ETN’s issue. Some ETNs are rarely bought and sold, making it difficult for prospective buyers and sellers to get fair prices on the open market. This is fine if you want to hold your ETNs to maturity, but not if you’re looking to trade regularly.

4. Few Options for Income Investors

Like bonds, ETNs have a set maturity date and are backed by their issuer’s faith and credit, but there’s one glaring difference: Few ETNs make regular interest payments. They don’t make regular capital gains or dividend distributions either, unlike many ETFs. While this simplifies ETN-related tax considerations, it’s not an attractive option for income investors.

Final Word

ETNs are often described as a cross between ETFs and bonds. Like ETFs, they trade on stock exchanges and are designed to mimic the underlying value of a particular index or asset basket. Like bonds, an ETN is backed by its issuer’s promise to repay, and is therefore heavily dependent on the issuer’s credit rating.

Since they don’t own the assets they track, ETNs offer the relative advantage of access to illiquid assets without the logistical headaches associated with actual ownership. Plus, this structure allows them to perfectly track their underlying index or assets, and simplifies their holders’ tax considerations. However, they’re a poor choice for those seeking income from interest payments or dividends.

Are you one of the relative handful of retail investors who have owned an ETN? How would you rate your experience, and would you recommend it to a friend?

Brian Martucci
Brian Martucci is a freelance journalist and branding consultant who loves to provide practical personal finance advice for regular people. When he’s not writing about frugal living, long-term investing, or consumer-friendly financial products, he’s probably out exploring a new trail or sampling a novel cuisine.

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